Advanced Bond Analysis · Bonds Explained

Specify the scenario before calculating

A stress test asks what might happen under a stated set of changes. It does not assign a probability unless you explicitly add one. Define the horizon, yield curve movement, spread change, currency assumptions and trading conditions.

An instantaneous repricing exercise differs from a one year total return estimate. The latter also includes income, reinvestment, defaults, costs and the securities becoming closer to maturity.

Keep rate and spread shocks separate

Consider a hypothetical $100,000 credit portfolio with rate duration 4 and spread duration 3. Assume benchmark yields rise by 1 percentage point and credit spreads widen by 0.5 percentage points.

A simple first order estimate gives a $4,000 rate loss plus a $1,500 spread loss, or $5,500 in total. This assumes the sensitivities are measured consistently and apply to distinct shocks. If you already used a total yield change, adding the spread shock again would double count it.

Add realism without pretending precision

Large moves require more than a linear approximation. Reprice cash flows, allow for convexity and changes in calls or prepayments, and test uncertain recovery values. Include an adverse currency move for unhedged foreign positions.

Liquidity costs can rise at the same time as credit losses. An evaluated price may not be executable for the whole position. A scenario that assumes frictionless selling during stress can understate the practical problem.

Turn the result into a decision

Compare the stressed value with required spending and available reserves. Identify which exposure creates the shortfall. Possible responses include reducing concentration, shortening a mismatch or holding more liquidity, but each has costs and must fit the objective.

Use several scenarios, including one that challenges your preferred market view. Record the assumptions so that another reader can reproduce the result rather than treating the output as an unexplained forecast.

Try it yourself

A $50,000 position has rate duration 5. A small parallel benchmark yield rise of 0.4 percentage points is assumed, with other factors unchanged. What is the first order loss?

Show the worked answer

The estimated decline is 5 × 0.004 = 2%, or $1,000. It excludes income, convexity, credit changes and trading costs.

Further reading

Educational material. Examples are hypothetical and do not recommend a security or a personal allocation. Contract terms and market conventions vary.

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